The Snowball

by Alice Schroeder

  Strangely, no one took him up on this offer. Instead, Silicon Valley suited up for another fight in Congress. But one by one, other companies began to follow in the footsteps of Coca-Cola and the Washington Post Co., announcing that they, too, would recognize the expense of stock options on their books.

  A year later, on the final Saturday morning of Sun Valley ’03, Bill Gates spoke, and announced that Microsoft was discontinuing the use of stock options. It would simply pay people a different way. From now on it would use restricted stock—stock that could not be sold for some time. This move took considerable guts.

  “There was a lot of pressure on Microsoft not to do it—a lot, a lot. The Silicon Valley reaction was—traitor. Microsoft had a lot of PR people around, advising him what to do. One of them told Gates it was like tossing a match into a room full of gasoline.

  “And my reaction to that was, they’re the ones that filled the room with gasoline.”

  The battle over stock options would continue formally for nearly two years, until the Financial Accounting Standards Board finally made it official. But Coca-Cola’s decision had kicked over the domino in a chain of events, and Microsoft’s action had broken through the wall of Silicon Valley solidarity that had given the technology industry a united lobbying voice in Washington.

  Buffett’s momentum as an influential statesman during this period was gathering speed. Although the estate tax was still scheduled to be repealed, he found another target in the accountants who had facilitated the accounting frauds of the past few years. If the auditors had not been sitting in the laps of the CEOs, wagging their tails, he felt, then managements would not have been allowed to loot the shareholders’ pockets, transferring vast sums into their own pockets. Buffett appeared at an SEC roundtable on financial disclosure and oversight, saying that, instead of lapdogs, shareholders needed guard dogs, and directors who served on audit committees and oversaw the auditors must be “Dobermans” who “hold the auditors’ feet to the fire.”40

  He said he had a short set of questions for the audit committee at Berkshire Hathaway:

  —If the auditor had prepared the financial statements herself (as opposed to their being prepared by the company’s management), would they have been prepared the same way?

  —If the auditor were an investor, could he understand how the company had performed financially from the way the financial statements were presented and described?

  —If the auditor were in charge, would the company follow the same internal audit procedures?

  —Did the auditor know about anything the company had done to change the timing of when sales or costs were reported to investors?

  “If auditors are put on the spot,” Buffett said, “they will do their duty. If they are not put on the spot…well, we have seen the results of that.”41

  These simple questions were so obvious, so clearly defining of right and wrong, so self-evidently useful in sorting out the truth and preventing fraud, that at least one or two other companies with directors who had common sense and were concerned about their exposure to liability from lawsuits actually copied Buffett and began to use them.

  As Buffett swung his saber with ruthless accuracy, and accountants cowered and compensation committees ducked and muttered about why he publicized their bonus-pimping instead of just shutting up, and as would-be tax-cutters tried to find even nastier terms than the ultimate pejorative, “populist,” to throw at him, so encouraged was Buffett by all this newfound authority that in the spring of 2002 he outdid himself and endorsed…a mattress. He let himself be photographed lounging on the “Warren,” part of the “Berkshire Collection,” sold by the Omaha Bedding Co., as seen on posters of “Buffett and His Bed.” Now when he went down to the Nebraska Furniture Mart during the shareholder meeting weekend, he could lie on his own bed while selling his own mattresses. “I finally landed the only job I really wanted in life—a mattress tester,” he said.42

  The Sage of Omaha, at whom plutocrats railed and tax-cutters shook their fists, before whom accountants quivered and stock-option abusers fled, whom autograph-seekers followed and television lights illuminated, was at heart nothing more than a starstruck little kid, endearingly clueless in many ways about his place in the pantheon. He got excited over and over by fan letters from Z-list celebrities. Every time somebody wrote him to say he was their hero, it was like the first time. When porn star Asia Carrera called him her hero on her Web site, he was thrilled. He was thrilled to be anybody’s hero, but being called a hero by a porn star who was a Mensa member had real cachet. His favorite letters were from college students, but when prisoners wrote and said he was their hero, he was proud that his reputation extended to convicts who were trying to turn around their lives. He would much rather be idolized by porn stars and college students and prisoners than by a bunch of rich businessmen.

  All this basking in the limelight meant that Debbie Bosanek and Deb Ray had to guard the phone and the door with dogged vigilance. Once, an overexcited woman who flew from Japan to get his autograph arrived in the office. She was so overcome by Buffett’s presence that she prostrated herself to “worship” him and had a sort of conniption on the floor. The secretaries hustled her out.

  She wrote later that her doctor had given her tranquilizers, and she hoped to be allowed in Buffett’s presence again. She sent photographs of herself and wrote letters.

  “I like being worshipped,” Buffett said in a plaintive tone. Nevertheless, the secretaries had their way and the woman wasn’t invited back.43

  57

  Oracle

  Omaha • April–August 2003

  Buffett seemed to thrive like a trumpet vine as he grew larger than life. Yet he remained brilliant at balancing his priorities. As requests for his time grew, his view that commitments are sacred and his natural inclination to conserve energy saved him from succumbing to the flattery of being in demand. He did only what made sense and what he wanted to do. He never let people waste his time. If he added something to his schedule, he discarded something else. He never rushed. He always had time to work on business deals, and he always had time for the people who mattered to him. His friends could pick up the phone and call him whenever they liked. He managed this by keeping his phone calls warmhearted and short. When he was ready to stop talking, the conversation simply died. The kind of friends he had didn’t abuse the privilege. While he had many fond acquaintances, he added true friends only at intervals of years.

  Susie added new “friends” at intervals of days or weeks. Kathleen Cole handled a gift list that had grown to literally a thousand people. Susie called herself a “geriatric gypsy” who lived in the sky. Cole smoothed the way logistically for her to travel for months on end—visiting grandchildren, caring for the sick and dying, vacationing, traveling on foundation business, seeing Warren and the family at scheduled times. Cole packed and unpacked for her, managed her three homes and staff, juggled the NetJets timetable, made the hotel reservations, scheduled the pedicures, fended off the phone calls, and organized the latest treasures from Susie’s shopping trips.

  Not only was Susie a woman who couldn’t say no; she was a woman who couldn’t be reached. Susie was such a nomad, she was so helpless to limit her attention to anyone, and the number of people who felt they had claim to her time had grown so astoundingly, that by now even her close friends were allowed to contact her only through Kathleen.

  Some who loved her grew concerned, although they rarely saw her to say so. “No one can have three or four hundred genuine friendships,” argued one. She seemed to run faster all the time. “All this chasing, like chasing your tail,” was another friend’s reaction. “You can’t have friends if you’re not around.” But “if you’re ill,” Susie said, “I’ll have plenty of time for you.” Some felt that her compulsion to serve and please had replaced living life in a straight line toward goals of her own. “She never spoke her own truth,” said one. The metaphysically minded found it significant that her health proble
ms arose in the throat and the gut; they associated the constant accumulation of collections and possessions and nonstop redecoration as an expression of what she was holding in. “Her life got heavier and heavier,” one person said. “Stop!” another wanted to tell her. “Get some perspective and nurture yourself.” But “it was as if she couldn’t slow down, because if she did, something would happen.”

  Yet many others called her a saint, an angel, and even compared her to Mother Teresa. She gave so much of herself to so many that she struck people as fragile now; the warm woolen cloak she wore against the harshness of the world had grown lacy and thin. But isn’t that the nature of a saint, mused one friend, to give of herself until nothing was left? Isn’t that exactly what Mother Teresa did?1

  Susie had foot surgery in the spring of 2003 and had to give away her beloved Manolo Blahniks.2 While laid up, she wrote out her usual list of “nine hundred” things for Kathleen Cole to do. The second the doctor released her, she sprang out of bed and off she went. When she traveled, Susie had a decided preference for five-star service most of the time—although many people had the impression that she usually slept on the floor in a hut. It was true, however, that she sometimes traveled without complaint in circumstances that would daunt many people. Susie sometimes actually did sleep in a hut, even though she suffered from acid reflux and a tendency toward esophageal ulcers severe enough that she normally had to sleep propped up at a forty-five-degree angle.

  Warren wanted to spend time with her so badly that he agreed to go to Africa to celebrate her seventieth birthday. Howie had started planning this trip, which was to take place late in the spring of 2003, eighteen months earlier. “It would have been the eighth wonder of the world to see my father in Africa,” he says. The Buffetts were going to Londolozi and Phinda, two seven-star safari resorts in South Africa. Howie traveled to Africa often; in a characteristic move, his mother had gotten him interested in photographing the suffering people of the continent as well as its wild animals. For his father, he was having a Wall Street Journal and a New York Times flown in daily on the trip. “It would be three days late,” Howie says, “but they would get the papers to him. It was going to cost five hundred bucks a day, but they would hook it up so he could be online in his room and check the news. They already had the hamburger and french-fry thing down because they do that for me.”3 The Buffetts would be leaving for Africa a few weeks after their annual trip to New York, which always followed the annual shareholder meeting.

  On April 1, 2003, as the shareholder meeting drew near, Berkshire announced the acquisition of a mobile-home manufacturer, Clayton Homes. This deal was like many others Berkshire was making at the time—a natural continuation of buying discount assets in the post-Enron slump.

  The Clayton deal had come about because years of low interest rates had given lenders piggy banks full of cheap money, and that had turned them into pigs.4 Banks were quick to train consumers that low interest rates meant they could buy more stuff for less cash outlay now. Those with equity in houses learned it could be used as a checking account. But whether it was credit cards, houses, or mobile homes, the lenders, in search of growth, increasingly turned to people who were the least able to repay—but wanted to participate in the American dream anyway.5 In the case of mobile homes, the banks lent money to the manufacturers, who used it to lend money to the buyers. Historically, this process had worked, because if the mobile-home maker made bad loans, it faced the discipline of not getting paid back.

  But then the mobile-home makers began to sell their loans, handing off the risk of not getting paid back. That was now somebody else’s problem. The “somebody else” who had assumed the problem was an investor. In a process known as “securitization,” for some years, Wall Street had neatly packaged loans like these and sold them to investors through a “collateralized debt obligation,” or CDO—debt backed by the mortgages. They combined thousands of mortgage loans from all over the U.S. and sliced them into strips called “tranches.” The top-tier tranches got first dibs on all the cash flow from a pool of mortgages. The next tranches had second dibs, and so forth down the line.

  These tranches allowed a rating agency to assign the top AAA rating to the first-dibs tranches, AA ratings to the second-dibs tranches, and so on. The banks sold off the tranches to investors. The banks analyzed the likelihood of default using a model based on historical repayment patterns. The lending system was changing, however, so that history was becoming less relevant.

  As lending standards declined, the hedge funds investing in CDOs took on more leverage, as much as $100 in debt per dollar of capital, and the quality of the CDOs—even AAA CDOs—got sludgier. Some investors did get nervous about the more obviously phony aspect of the way the market was operating and wanted to hedge their bets.6 They tapped into a market that had developed to bet on whether loan defaults would occur: the credit default swap. If a securitization lost value because loans defaulted, the issuer of the swap would have to pay.

  Protected by credit default swaps, investing in CDOs now appeared to contain no risk. “When money is free,” wrote Charles Morris later, “and lending is costless and riskless, the rational lender will keep on lending until there is no one left to lend to.”7

  If it was pointed out that risk did not disappear, those who participated in the market would explain with a sigh that securitization and swap derivatives “spread” the risk to the far corners of the globe, where it would be absorbed by so many people that it could never hurt anyone.

  Thus freed, the rational people of the mobile-home business had lowered down payments, making it much easier to get loans. As the real-estate market boomed, riskier types of home loans—along with commercial and business and student and other loans—spread like a cold virus in a kindergarten. These, like the mobile-home loans, were stripped, insured, “securitized,” and speculated on over and over through credit default swaps. Meanwhile, other, more exotic derivatives proliferated.

  In his 2002 shareholder letter, Buffett called derivatives “toxic,” and said they were “time bombs” that were expanding unchecked and could cause a chain reaction of financial disaster. At the shareholder meeting that year, Charlie Munger described the accounting incentives to exaggerate profits on derivatives, and concluded, “To say derivative accounting in America is a sewer is an insult to sewage.” In his 2003 letter, Buffett wrote of derivatives as “financial weapons of mass destruction.”8 So many of these deals existed, he wrote, that they had formed a daisy chain around the globe. Despite the advice of their mathematical models to buy rather than sell into a crisis, when trouble approached, investors fled their watering hole like a herd of giraffes escaping a lion. And while many people appeared to be participating in a market, in fact a handful of large financial institutions would always tend to dominate it using their leverage. They would also have other assets that seemed uncorrelated with these derivatives but which would actually move in tandem with the derivatives in a collapsing market.

  General Re had a derivatives dealer, General Re Securities, which Buffett had shut down, either selling its positions or letting them run off in 2002. He had already turned Gen Re Securities into the cautionary tale of derivatives—writing at length to the shareholders about the expensive and problematic cost of shutting it down. General Re had made Buffett so angry by losing almost $8 billion by now from insurance underwriting that he could barely talk about it. The Scarlet Letter remained posted on the Berkshire Web site, though Ron Ferguson had retired, replaced by Joe Brandon and his number two, Tad Montross. General Re’s competitors gleefully told clients that Buffett was going to sell the company or shut it down. Given the example of Salomon, these predictions were not spun from gossamer. Buffett had taken away part of General Re’s new business after 9/11 and given it to Ajit Jain’s Berkshire Re, rather than infuse more capital into General Re to shore up its balance sheet.9 He had also started funding competitors of General Re through Jain and through Lloyd’s of London. He rationa
lized this in various ways; he himself may not have recognized a classic pattern—when anxious, Buffett always sought escape hatches and trapdoors. He was not “punishing” General Re; rather, Buffett was instinctively hedging the risk that General Re was going to underwrite itself, his $22 billion investment, and his reputation into the ground.

  It was going to take billions of profits before General Re groveled its way back into Buffett’s good graces. Its derivatives business would have little to do with that, either way. The same was not true for the global economy. By a “low but not insignificant probability,” Buffett said, sooner or later—he didn’t know when—“derivatives could lead to a major problem.” Munger was more blunt. “I’ll be amazed,” he said, “if we don’t have some kind of significant blowup in the next five to ten years.” While many safeguards had been put in place to protect investors in stock and bond markets, derivatives were lightly regulated and subject to minimal disclosure. Since the early 1980s, “deregulation” had turned the markets into the financial equivalent of a rugby scrum. The theory was that the market’s forces were self-policing. (And yet, the Fed did seem to intervene at times when trouble cropped up.)

  By “problem” and “blowup,” Buffett and Munger meant that a bubble was brewing in this witch’s cauldron of easy credit, lax regulation, and big paydays for the banks and their accomplices. They meant an unsnarlable traffic jam of claims from derivatives leading to financial-institution failures. Large losses at financial institutions could lead to a credit seizure—a global “run on the bank.” In a credit seizure, lenders become afraid to make even reasonable loans, and the resulting lack of financing sends the economy spiraling downward. Credit seizures had in the past tipped the economy over the edge into depressions. But “that’s not a prediction, it’s a warning,” said Buffett. They were giving a “mild wake-up call.”